The Sharman Inquiry: Going Concern and Liquidity Risks

Thursday, May 12 2011 by
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The Sharman Inquiry Going Concern and Liquidity Risks

On 8 March 2011, the FRC (Financial Reporting Council) announced the launch of an Inquiry led by Lord Sharman to identify lessons for companies and auditors addressing going concern and liquidity risks. On 11 May 2011, the Panel of Inquiry published a Call for Evidence requesting written submissions by 30 June 2011. Now, this may appear to be a rather dry topic but it ought to be of supreme concern to all investors.

The biggest concern, when making an investment, is whether there is much likelihood of the company you're investing in going bust. Anything that offers greater clarity on risk factors affecting a business is to be welcomed - as long as it doesn't simply lead to more meaningless verbiage in company reports. In my personal experience there have been cases where matters that have not been properly disclosed to shareholders or potential investors arise and may have a terminal (or near terminal) effect on a business. This calls into question the effectiveness of the current audit system - and of current penalties for deliberate misleading of investors.

You can make a difference by providing ShareSoc with evidence of specific examples of where the current system has failed to uncover risks that ought to have been apparent to managers and investors. I doubt that generalities or non-specific complaining will have much impact.

ShareSoc intends to submit evidence to the inquiry on behalf of its members. I feel that a submission by an organisation representing a substantial number of investors will carry more weight than submissions by individuals. If you are not already a member, you can join as an associate for free (though donations would be appreciated!). Once a member, you can provide your evidence to us through our member network, by e-mail or by non-electronic means.

We need your input (by 15th June, giving us time to collate, formalise and submit it) - all help appreciated!

Mark


Filed Under: Regulation, Audit, Liquidity, Solvency,

About the Author's Website

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ShareSoc - UK Individual Shareholders' Society

ShareSoc is a not-for-profit campaigning organisation, promoting individual share ownership, fighting for shareholder rights and providing educational resources to investors. ...read more or visit website »


Disclaimer:  

The author may hold shares in this company, all opinions are his own and you should check any statements that appear factual and not rely on them before making an investment decision. The author is NOT a qualified analyst nor authorised to give investment advice. Whilst the author is a director of ShareSoc, all views expressed are entirely his own and not necessarily those of ShareSoc.


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20 Comments on this Article show/hide all

marben100 5th Jul '11 1 of 20
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Sharesoc has now made its submission to the Sharman enquiry: http://www.sharesoc.org/Sharman_Response.pdf

Having examined various cases brought to my attention (and some of which I have direct personal experience), time and again I observe that directors and auditors are not brought to book for questionable accounting, failing to detect blatant poor practice or otherwise extracting value from businesses at shareholders' expense. Hence the thrust of our response is that rather than adding more impenetrable verbiage to company reports, what is needed is an effective regime for reporting questionable behaviour, with feedback to the reporter, and meaningful penalties for wrongdoing.

In my experience, the absence of such a regime and penalties means that some individuals feel that they can plunder shareholders' funds with impunity. This has to stop!

We also endorse the principles set out in the report "Tomorrow's Corporate Governance". In this report mechanisms for restoring control of nomination, remuneration and audit committees to shareholders - as has been implemented in Sweden - are set out.

If you support our efforts please join us - which you can do free, as an associate member, though donations are always very welcome.

Mark

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nigelpm 5th Jul '11 2 of 20
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time and again I observe that directors and auditors are not brought to book for questionable accounting


Let's be very clear here.

It is solely the directors' responsibility to ensure that a company accounts correctly.

The auditors' responsbility is to detect material misstatement (which may or may not be brought about by the above) but NOT ensure a company accounts correctly.

It might seem trivial but there's a very clear distinction.

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marben100 6th Jul '11 3 of 20
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In reply to nigelpm, post #2

Hi nigelpm,

Sorry - a case of poor sentence construction. :0) You are, of course, right: the auditors are solely responsible for verifying the accuracy of the accounts, including accounting judgements.

However, in preparing our submission, not only have I been informed by my own experience but also have had the benefit of the knowledge of one of our members, who happens to be a highly experienced auditor. His description of how the audit of a FTSE100 firm is conducted appals me. In particular, he describes a very cosy relationship* between audit firms and the Boards that currently appoint them, exposing the flaw in the Board being responsible for appointment of the auditors. I also understand that the audit partner, who is nominally responsible for the audit, tends to participate in a very limited manner in supervision of the audit. The real work is delegated to junior staff, many of whom are too inexperienced to actually detect fraud when it occurs. That's how cases such as Enron can occur - and goes to the heart of what Sharman should be investigating.

*Including lavish "audit dinners", sports days, golf days etc.

The Aero Inventory example I cited in the submission illustrates the problem with the absence of a transparent investigation mechanism. Investors have no idea whether an investigation has taken place, is currently underway or what results are. Without such an investigation we do not know how the fundamental misstatement of accounts admitted by the company occurred - and to what degree their auditors were culpable in not detecting this failure. Many investors (both private and institutional) will have lost considerable sums as a result. They ought to be entitled to know why their business failed and that anyone culpable for that failure has suffered an appropriate penalty - especially any culpable persons who benefitted from investors' funds.

Regards,

Mark

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nigelpm 6th Jul '11 4 of 20
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In reply to marben100, post #3

That might be the public perception and certainly was the case before Enron, Worldcom et al but there's been a huge effort to clean up the cosy tie ins.

It's certainly not perfect but the situation you refer to in the above is not a fair reflection of how it currently is.

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snaj 7th Jul '11 5 of 20
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Mark

Did you come across or reference in your ShareSoc work, an article (or articles) written by Alastair Blair in the Investor's Chronicle a few years ago regarding his suggestion to replace 'auditors' with 'validators'?

I think Nigel is right to some extent in that the few bad apples have been rooted out, not that there were that many 'rotten' apples to begin with - their effect however was disproportionate when it came to informing the public's perception of accountants in general.

What you describe above in relation to the balance of work between partners and junior staff is however difficult to change unless audit fees are raised in general, but conditions are not conducive to this particularly as audits are seen as loss-leaders for other services in a market that is already too price-competitive and not quality-competitive.

Regards

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emptyend 7th Jul '11 6 of 20
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In reply to snaj, post #5

What you describe above in relation to the balance of work between partners and junior staff is however difficult to change

I think one needs to be realistic here. There isn't a profession on the planet (well....perhaps only one ;-)) where the person primarily responsible for the provision of the service actually does the bulk of the work themselves! It doesn't matter whether one is looking at law, medicine, accounting, banking or anything else.....the guys at the top get to go home earlier than the guys at the bottom.

As to the point about detection of fraud (and other matters that might damage shareholder value) I would say that it is really REALLY difficult from people to find problems unless the auditors have turned up something that doesn't quite look right.  In the case of "ordinary frauds" that have been carried out by people who are knowledgable re accounting systems, the chances are it will only be detected by some sort of forensic accounting. And in the case of fatally flawed, but widely shared, misunderstandings of the financial picture (such as happened with eg Enron and most of the banks) this can only be detected by people being prepared to challenge the shared assumptions - and that is likely only to happen if someone has some knowledge of the potential problems......

....for example, I like to think that if I had been anywhere near a bank boardroom I might have had some of the drains up on the way their businesses were being run pre-2007 - though whether I would have found and corrected the very particular problems that took down some of the banks might have been a different matter entirely. Nevertheless, it is a good deal more reasonable to expect directors to challenge the "big picture" issues of risk management and accounting assumptions, than to expect them to find a financial fraud buried in the books that has been well-enough disguised to fool reputable firms of auditors.

ee

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nigelpm 7th Jul '11 7 of 20
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In reply to emptyend, post #6

Spot on ee and good post from snaj as well.

My feeling on this whole discussion (and it's very worthwhile one to have) from an investment perspective is that you need to be invested in a firm where shareholder interests are aligned with that of the directors.

Whether this is through share options, bonus schemes (that are sensible!) or the management just having large stakes (ala Soco/Heritage) human nature being what it is you aren't going to EVER eliminate the problem.

As things exist it's probably "good enough" and I suspect that will be the reason why it's not seen as large enough issue generally.

All that said, I really like some of the ShareSoc ideas and have joined so let's see what we can achieve ;-)

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marben100 9th Jul '11 8 of 20
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In reply to nigelpm, post #7

Hi nigelpm,

As things exist it's probably "good enough"

There I have to disagree most strongly. The current system most certainly is not good enough. it leads to fundamental conflicts of interest where:

  • Directors appoint each other. This may lead to a temptation not to appoint anyone who asks too many difficult questions, and as a result Boards may be packed with cronies and stooges.
  • Boards set their own remuneration, leading to this (from last year):

New figures out today revealed FTSE 100 director pay shot up by 55pc in the 12 months to June. In the FTSE 350, total boardroom pay climbed by 45pc on average, the figures by IDS found.

The statistics came less than 24 hours after a survey by the same consultancy found 16pc of employers were still pushing through pay freezes, effectively passing on pay cuts to staff when inflation was taken into account.

FTSE 100 chief executives took home £4.9m on average in total earnings during the year, the report showed.

and this (from a couple of weeks ago):

Directors in Britain's top 100 companies have accumulated final salary retirement pots worth £2.8m on average, according to figures that reveal a widening gap between the 

the pensions awarded to boardroom executives and the shop floor 

Incomes Data Services (IDS) said about 46% of FTSE 100 directors were still accruing final salary benefits in generous schemes that typically pay two-thirds of final salary as a retirement income

 

  • Directors appoint and determine the remuneration of supposedly independent auditors. This puts auditors in a difficult position: will they want to upset their clients by raising difficult issues and taking a more cautious view of assets or profits than the FD may wish to see?

 

When it comes to aligning directors' interests with those of shareholders, rather than substituting share-linked and performance related pay for fixed remuneration, this has recently led merely to an extra layer of pay. Recent FTSE250 CEO remuneration packages I have examined consist of:

  • A basic salary of an already generous £0.5m
  • A cash bonus of 100%+ of basic
  • A "share incentive plan", also typically 100%+ of basic

 

Whilst the latter two elements are performance linked, the achievable incentive seems grossly excessive to me and to other ShareSoc directors.

 

ee,

I understand that the audit team for a FTSE100 company typically comprises 10-30 staff. I do not expect that the audit partner will be personally examining ledgers. However, it has been the case that audit partners have acted more as salespeople, schmoozing their clients, than taking assertive control of the audit process and becoming personally concerned with critical issues.

The reason that the Sharman Inquiry was established in the first place was to examine lessons regarding liquidity and going concern status that could be learnt in the aftermath of the banking crisis. Examination of the audit process and the relationship between auditors and their clients is part of this. I have not commented directly on these issues in our submission as they're beyond my sphere of competence. However, surely one of the key factors in the banking crisis was the employment of highly complex financial instruments, which disguised risk? Isn't part of the audit function for banks to determine the adequacy of banks' risk management systems, which should have involved an assessment of the judgements of value and risks of these instruments. This cannot be done by a junior but requires an experienced specialist. Is too much delegated to too low a level?

 

It is time for these various conflicts of interest to be eliminated by delegating the decisions regarding nomination and remuneration of directors and auditors  to a shareholder-led committee making recommendations to the AGM for general approval by shareholders.

Regards,

Mark

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emptyend 9th Jul '11 9 of 20
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In reply to marben100, post #8

I have not commented directly on these issues in our submission as they're beyond my sphere of competence. However, surely one of the key factors in the banking crisis was the employment of highly complex financial instruments, which disguised risk? Isn't part of the audit function for banks to determine the adequacy of banks' risk management systems, which should have involved an assessment of the judgements of value and risks of these instruments. This cannot be done by a junior but requires an experienced specialist. Is too much delegated to too low a level?

Regarding the banks specifically, I can tell you that I have personally been asked to explain various "complex instruments" to various auditors ....and that goes back to at least the mid 1990s. Instruments got much more complex later.

Your assertion which I have emboldened is completely wrong.....because the only "experienced specialists" were employed by the banks - nobody outside the front line of banking had the slightest idea and everyone outside the banks themselves would have needed things explained to them. Furthermore, age and "experience" is utterly irrelevant when dealing with what might be termed "new technologies". Indeed there is a strong case for arguing that the more junior people are the more open-minded and inquisitive....as well as perhaps more technically capable.

For an analogy, consider asking your father to explain how computer programmes work. ....And remember that the bank boardrooms were stuffed with highly experienced businessmen - but they knew absolutely diddly-squat about modern banking instruments. I made this point very forcibly at the time (2005/6 ish) on TMF but virtually everyone ignored it!

Finally I note that EVERY senior person in every profession is (to a greater or lesser degree) a salesman - as well as being a manager. It is completely ridiculous, as well as prohibitively expensive, to expect an army of technocrat experts to be magicked up from nowhere and deployed on doing the grunt of audits. It is simply a completely unrealistic idea that is utterly unworkable.

Eliminating conflicts of interest is another matter - but I'd suggest sticking to such issues of principle rather than getting sidetracked onto barking impracticalities.

rgds

ee

ps...the problem with the banking system was mostly beyond the scope of the remit of individual auditors, because the primary issue was the system-wide nature of the risks that was mushrooming without any regulatory oversight. Other than issues of fraudulent mortgage applications (overstatements of value etc etc) it is unlikely that any auditor (experienced or otherwise) would have spotted the potential for systemic problems on the scale that emerged.

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nigelpm 9th Jul '11 10 of 20
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In reply to marben100, post #8


Directors appoint and determine the remuneration of supposedly independent auditors. This puts auditors in a difficult position: will they want to upset their clients by raising difficult issues and taking a more cautious view of assets or profits than the FD may wish to see?


Upset or not. It's their duty!

Ethical standards in accountancy have come a long way.

And any breaches of these are dealt with quite viciously by the institute.

I can honestly hand on heart say the accountancy profession in one of the most honest and ethical I've ever come across. 

If you have any specific examples of poor behaviour the insititute would I'm sure be happy to take action.

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marben100 10th Jul '11 11 of 20
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In reply to emptyend, post #9

ee,

Your assertion which I have emboldened is completely wrong.....because the only "experienced specialists" were employed by the banks - nobody outside the front line of banking had the slightest idea and everyone outside the banks themselves would have needed things explained to them.

I take issue with that. My "assertion" is not completely wrong but maybe you misunderstood what I meant? By "experienced" I do not necessarily mean someone in their 50s. What I do mean is not someone who is freshly qualified and has no knowledge or experience of the instruments discussed, or of banking practice. If the audit firms do not have the necessary experience/expertise themselves, then they need to hire it in. How can they possibly do a proper job of protecting public, creditor and shareholder interests otherwise?

 

Coming back to snaj's point about charges, I agree. Whereas a Board committee hiring in an auditor may see little need to pay more than the minimum for audit services, if I were on a shareholder-led committee choosing an auditor, I would want to see a presentation from each potential firm. If a firm can justify the need for higher charges (e.g. by making a case for hiring specialist expertise, be that banking or oil industry for example) and I am satisfied that we would get a more thorough job (and it is wortwhile doing so) by paying more, then I wouldn't necessarily go for the cheapest bid. I am well aware of the old saw "pay peanuts, get monkeys".

 

My main point concerning audit and auditor appointment is that I have seen too many cases (e.g. Aero Inventory, Langbar, Nighthawk, RCG, Torex amongst many others) where shareholders have placed confidence in company accounts because they bear the "seal of approval" of having been officially audited, and then affairs do not turn out to be as represented in those accounts. That's why I maintain that something needs to be done and I believe we have an entirely practical proposal for doing something. See the Tomorrw's Company report referenced in #1 above, describing how the proposed system has been successfully implemented in Sweden.

Regards,

Mark

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emptyend 10th Jul '11 12 of 20
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In reply to marben100, post #11

maybe you misunderstood what I meant? By "experienced" I do not necessarily mean someone in their 50s. What I do mean is not someone who is freshly qualified and has no knowledge or experience of the instruments discussed, or of banking practice. If the audit firms do not have the necessary experience/expertise themselves, then they need to hire it in. How can they possibly do a proper job of protecting public, creditor and shareholder interests otherwise?

The point that I was making was that no such people existed. I can tell you with 100% confidence that c.99% of the people who had firsthand experience of these new instruments (such as securitisations, credit default swaps etc etc) were working for the banks. There WAS no pool of outside expertise for audit firms to draw on - even the regulators didn't have people with firsthand experience.

You make a fair point - how can they protect the interests of others without such expertise? And indeed it is true that in most of the products developed since the mid 1980s, there was close to zero knowledge outside the banks until at least 2000 (and probably rather longer).  For example, I was personally in a group that established the regulatory framework for the product group I was responsible for....we met regularly at the Bank of England, and had a Bank of England observer at our meetings - but that observer was just an "observer" for a very good reason.....which was that they were trying to learn how the market worked - and they didn't know enough to contribute, let alone to dictate! I've no doubt that products that came along later suffered a similar dearth of expertise (one reason why ISDA acquired so much power, so dangerously, and assisted in facilitating the growth of the hedge fund industry - who were major clients).

Regarding the appointment of auditors, it is my clear view that auditors should be favoured who have a strong overview of sector-specific accounting issues and practises. It isn't a matter of price. It isn't even just a matter of ethics. It is a matter of appointing someone with the sort of expertise that you were demanding in the context of banking - someone who will recognise the way things should be done and will insist (on pain of qualifying the accounts) that management adopt a prudent approach to the sort of occasionally-tricky issues that every industry faces from time to time.....

...and it follows from that, IMO,  that one doesn't rush to change auditors on a whim, just as they have got to the point where they have a useful understanding of the company and the industry context.

My general suggestion on auditors for shareholders is that they should be prepared to challenge auditors who don't have other clients in the same industry.....the sort of tiny country auditor who may (unintentionally!) collude with local firms is the sort of situation to be most wary of with smaller companies.

ee

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kirkie001 11th Jul '11 13 of 20
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Fascinating debate. And I can see both sides (or, to be honest, all 3 sides) - having been at various stages a private investor reading accounts; someone responsible for preparing FTSE 100 accounts, and someone responsible for auditing FTSE 100 financial statements.

The main problem is one of perception. The public perception of an auditor's role is to 'certify' that the accounts are 'correct' (I use quote marks advisedly, since neither of these comments is true). This is a million miles away from what their statutory duty is. An auditor employs an overall judgement, based on risk-based sample of accounting records and financial controls, that the financial statements are not 'materially misstated'.

There's also a perception that auditors should pick up on fraud. No - any fraud they come across is expected to be reported, but it is incedental to their role as opposed to an objective - 'reasonable expectation' is I think the phrase used, but again, that's a world away from what investors actually want.

And that's the difficulty. For what investors want, an audit would take twice as long - so ALL CORPORATE YEAR END REPORTING WOULD COME OUT at least 1-2 MONTHS LATER. I suspect that's a trade-off that investors wouldn't want.

OK, so we work to restrict timelines. Double the size of audit teams. Fine; but that will then double the audit fees. And you want more experience on the teams, rather than 22 year old Joe McSpotty? Fine - but you'll be paying for that as well. Double the revised fee again.

Oh - and the scope's not what you want? Fine - get auditors to expand the scope of what they do - but they'll want capped liability, and more fees again - after all, it's more work and more reports.

To be honest, I've never really come across a situation where there's been a conflict created because of an auditor doing non-audit work. That 'rule' has been in place for at least 10 years now, and it's always separate teams. And the big firms really do spread around the money they earn from clients - there's never any danger of a key-man dependency (really; the problem would arise one-tier down - think Parmalat and their auditors).

And lastly - in order for auditors to be able to do work properly, you have to get round the problem of who they work for. Management appoint them; management agree their fees, and management provide them with the info from which to do their audit. (a phrase about mushrooms, dark rooms, and fertiliser comes to mind!)

So what is needed? Here's my views:

- Audit tenders should be required every 10 years (more often than that is too soon).
- Audit tenders; proposed fees, etc, should be made public, together with the key assumptions.
- Audit partner rotation should be required every 5 years.
- Corporate Annual reports should be expanded to include enhanced reporting from the auditors. (why do you get a 20+ page report on corporate responsibility - who cares!! - and a 2 page report from the chairman of the audit committee?) The auditors planning report, or extracts should be published.
- The levels of materiality used by management and auditors should be published in the year end report
- Sox-style controls reporting should be considered (if there's some way not to make this a costly overhead which minimises the impact on small companies)
- Directors should be required to have some kind of more open-ended liability. How can it be right that the auditors have unlimited liability whilst directors don't? The directors are responsible for managing and preparing the numbers; the auditors get a fee for doing work on them.

But then, you've got all kind of problems. Many of the sources for the above are in corporate law - so CA2006 and its related items for the UK. But what about foreign incorporated companies? Does this mean that enforcement needs to sit with regulated exchanges? Again; this would be a hugh change in the way that business is done, and without a worldwide shift, would create and instant, and massive, competetive disadvantage.

So, in summary:

- auditors fees are too low, not too high, and need to rise commensurate with the risk they face;
- directors responsibilities need to be enforced; which they currently are not (rigorously enough);
- auditors and investors needs and duties need to be more closely aligned;
- the real "what's useful" in an annual report needs to be identified, built on, and published (as opposed to taken out because corporate counsel doesn't like it or feels it exposes people unduly). That then needs to be produced much more regularly than once a year.
- this can't be done in one jurisdiction in isolation, otherwise you'll just get regulatory or jurisdictional arbitrage taking place (to an even greater extent than currently).

One would hope that Lord Sharman would be in a good position to understand both sides of the argument, given his past and present employment history!

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marben100 11th Jul '11 14 of 20
1

In reply to emptyend, post #12

Hi ee,

Agree entirely with what you're saying there. Thanks for the "inside" info re what was going on in the banks: seriously scary and illustrates the dangers which still exist.

I agree 100% that choosing an auditor with the right expertise is the most important thing.

 

Unfortunately, I lost the first version of my post #8, due to a misclick. :0( In the original version I remember now that I did have an extra paragraph where I stressed that in the majority of cases there was no strong reason to doubt the integrity of directors or auditors. However, as in any walk of life, there are always "bad apples" and, at present, sanctions and transparency in the UK are too weak - in contrast, say, with the situation in the US where investors can expect miscreants to feel the full force of the law, when those investors have clearly and deliberately been misled.

Best,

Mark

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emptyend 11th Jul '11 15 of 20
3

In reply to kirkie001, post #13

Directors should be required to have some kind of more open-ended liability. How can it be right that the auditors have unlimited liability whilst directors don't? The directors are responsible for managing and preparing the numbers; the auditors get a fee for doing work on them.

I would have thought that the liability of Directors is already high enough, at least for non-executives.

Non-execs don't "prepare the numbers" either - but they perform a similar function to the auditors in challenging those who prepare the accounts and in seeking to ensure that the accounts are a true and fair view. Unlike the auditors, though, they then have to accept a collective responsibility for those accounts (whereas the auditors are covered by a disclaimer to the effect that they haven't found anything amiss)

Since I became a NED, various people have asked me whether I would recommend it. My answer is that it simply isn't worth the trouble/hassle/risks and potential call on one's time. In addition the rate of pay is appalling, the extent of ill-informed abuse from shareholders is surprising and the only compensation that offsets any of this disadvantages is that one can take some pride in fulfilling an essential function to the best of one's ability.

But, basically, you have to be mad.....or have some strong element of self-interest.  In my case I have a large shareholding to protect - but, set against that, I also have to accept considerable, onerous and potentially very costly restrictions on dealing. I have no doubt that, when opportunity costs are factored in, I am net out of pocket.

Accordingly, I would warn those who wish to impose more obligations on non-execs and/or auditors to be very careful indeed about what they wish for. As kirkie notes, auditing costs could rise substantially if auditors are asked to play a bigger role. Similarly, finding capable and independent non-exec directors will become even more difficult for companies than it already is - a situation that could be made worse by mass resignations (unless fees rise substantially to compensate for any additional risks and obligations).

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nigelpm 11th Jul '11 16 of 20

In reply to kirkie001, post #13

Great post Kirkie. Guessing you worked in audit for a while? ;-)


The main problem is one of perception. The public perception of an auditor's role is to 'certify' that the accounts are 'correct' (I use quote marks advisedly, since neither of these comments is true). This is a million miles away from what their statutory duty is. An auditor employs an overall judgement, based on risk-based sample of accounting records and financial controls, that the financial statements are not 'materially misstated'.


This is the crux and one of the main reasons why I picked Mark up on his post higher in the thread on something that usually would seem to be incredibly petty - and for which I apologise.

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nigelpm 11th Jul '11 17 of 20

In reply to emptyend, post #15

I think Kirkie is right but agree with you ee that it shouldn't include the NED's or IMHO Chairman.

Just the Exec Directors involved in the day to day function of the business and stewardship of shareholders' assets.

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emptyend 11th Jul '11 18 of 20

In reply to nigelpm, post #17

I think Kirkie is right but agree with you ee that it shouldn't include the NED's or IMHO Chairman.

I should have added that I think most of Kirkie's suggestions re audit were perfectly sensible.

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kirkie001 12th Jul '11 19 of 20
3

Hi ee / nigel: yes; you may have guessed that there was an auditor hidden in my dim and distant past...;)

Just to be clear, I agree with ee's views: the problems lie more (IMHO) with the executive directors and those one step below that, rather than the non-execs. Frameworks need to be designed whereby non-execs are freely able to express their views and report accordingly: perhaps some kind of non-exec report from each non-exec should be required at AGMs: might help to demonstrate govenance? But the larger problem is the executive directors: my point on liability would be aimed at them - as I said, it surely can't be right that an auditors' liability is open ended whereas [executive] directors are protected?

It also comes down to the aligning of interests and 'skin in the game' - a good way of aligning directors and shareholders interests is via shareholdings and entitlements. But there's also this dichotomy of [executive] directors having a cap on what can go wrong (or, as some like to view relationships in certain co's, where directors cream off salaries and bonuses and shareholders' value gets no benefit). Maybe it comes down to what Michael Lewis talked about re the old partnership structures in the investment banks - they didn't take the same risks when they were a partnership and it was their 'houses on the line'. Maybe something like that - not an incentive, but a good hard stick - needs to be introduced for execs, so that they are at least aligned with the auditors!

[*fat chance....*]

ee - would be massively interested in your views especially given your last 2 years of experience in a public company environment, with public company accountability.

Cheers
K

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emptyend 12th Jul '11 20 of 20
9

In reply to kirkie001, post #19

Frameworks need to be designed whereby non-execs are freely able to express their views and report accordingly: perhaps some kind of non-exec report from each non-exec should be required at AGMs: might help to demonstrate govenance?

Key committees (notably Audit and Remuneration) are (always?) chaired by the Senior Non-Exec Director who, as Chairman, has to sign the minutes of those committees. Non-execs also get the chance to discuss any accounting issues with the auditors, without execs being present. Any material issues identified in this process would normally be subject to reporting, either by the auditor or by comment in the annual report.

There is no substitute for a board who (as a whole) are prepared to take their responsibilities to shareholders extremely seriously; the problem for shareholders is that they cannot always assess whether this is the case from the outside. However, I don't think that a "special section" for NEDs to report would actually help at all. There are three reasons for that:

1) The most important/relevant issues are already covered in the Remuneration Report and the Audit Committee report, which should highlight any matters that received particular consideration during the year. Obviously such reports are approved with particular care by the Committee Chairman - and indeed the whole Annual Report is approved by the whole board.

2) There are always going to be issues which have been particularly examined and argued about within a board. However, it isn't (generally) likely to be of any help to the company and its shareholders to highlight any differences of view within the board - though it may very well be of assistance to competitors. A properly-functioning board should be able to have full, frank and robust discussion of the full range of relevant matters, without risking undermining the agreed positions adopted at the end of such discussions.

3) Presentation of reports in the way you suggest really cannot be taken as being any more reliable or useful than the present system - and IMO it would be much more difficult and cumbersome (aka costly) to coordinate the production of the AR. Those who are determined to "fake it" would still be able to do so, especially if the non-execs were overly compliant.

it surely can't be right that an auditors' liability is open ended whereas [executive] directors are protected?

I'm not sure why you think that directors are "protected". Auditors always protect themselves in their Report to shareholders to some extent - not least by pointing out that they are only offering an opinion and not a guarantee!

It also comes down to the aligning of interests and 'skin in the game' - a good way of aligning directors and shareholders interests is via shareholdings and entitlements. But there's also this dichotomy of [executive] directors having a cap on what can go wrong (or, as some like to view relationships in certain co's, where directors cream off salaries and bonuses and shareholders' value gets no benefit).

I agree about "skin in the game". This is why Directors' dealings should be of some interest to shareholders - though of course there is no guarantee (I once bought shares in Mayflower PLC, following several Director buys at 247p.......and the company was bust due to fraud a couple of years later!).

As regards salaries and bonuses, it is very fashionable indeed for shareholders to carp about anyone being paid anything!!! Sometimes their concerns are extremely well-justified....but more commonly their complaints are entirely misplaced (and often mischievous, IMO). There are three or four issues to watch for:

a) Overall pay levels compared to companies with a similar scope of business (nb this DOESN'T always mean that they will have similar market caps!)

b) The rate of increase in pay levels (assessed over periods of at least 3-5 years, to avoid short-term distortions arising from "catch-up" increases for people who have had no increase for some while....or arising from, for example, differences between the currency in which individuals are paid and the reporting currency in the accounts).

c) The actual amount of CASH compensation being paid out of the business. For example, option awards are subject to an accounting charge that is sometimes presented in the accounts as part of Directors' compensation (as with Aminex, for example......even though the Directors don't actually receive a penny of cash - nor a penny of value, unless the share price goes up, since they have to pay the market price as at the time of grant) and in other cases (such as SOCO) the accounting charge is simply treated as an aggregate charge in the accounts and not separately identified in the Directors Emoluments table (as an accountant, kirkie, you may have a better idea than me about why these differences of presentation occur?)

d) The precise terms of any option awards - and their scale and frequency. One of the biggest differences that non-accountants seem to gloss over is whether the award of options or LTIP shares is subject to any performance conditions and/or requires the recipient to pay any cash when exercising the options. Some companies award options with an exercise price of zero, whereas others require payment of the market price at the time of grant (or something based around that). There is a WORLD of difference in value to the recipient.

If one considers these points quite rigorously (and, frankly, few people have the required voracious appetite for reading the minutiae of company accounts!) then it isn't very difficult IMO to identify which management teams are "creaming off" excessive amounts and which are relatively well-aligned with shareholders' interests.  There is a need to pay good people well enough that they stay with a company and to provide incentives for them that are aligned with shareholders interests (ie which enrich the company's management if the shareholders are also being enriched - but which DON'T enrich them if the shareholders are not demonstrably gaining value)........ and it is disingenuous of some people to suggest that a well-run company can be run much differently......

One important rider to that issue is that if one is looking at companies which are potential "growth" situations, then management needs to have sufficient equity incentives to produce enough opportunities to achieve that growth (otherwise they may just avoid the risk of failure and just keep drawing their salaries). Conversely, if one is looking at a "utility" situation which is all about income and not about growth, then equity incentives can be substantially lower. In all cases, of course, there would be some sort of minimum "rate for the job" (on which topic I would also observe that those who comment on these things should always ensure that they convert the reporting currency into GBP....which doesn't always happen AFAICS! ;-))

Finally, just on the subject of Boards and refreshment of non-execs, perhaps there could be a way of more easily formally proposing a "slate" of potential non-exec director candidates for the Nominations Committee to consider?  There is some significant practical difficulty in forming such a slate of suitably-qualified candidates, but the internet should make this much easier today than has historically been the case.  Suppose, for example, that every company's Nominations Committee was asked by a group of shareholders to formally consider a list of 3-5 potential non-execs some 6 months ahead of the AGM........the Nominations Committee would then have the time to consider these potential candidates and decide whether any of them would be better than any of the existing non-execs who would be retiring by rotation at the AGM and seeking re-election. If they felt there was a clear improvement, they could simply suggest that the existing non-exec(s) retired at the AGM without seeking re-election and invite shareholders to support one or more of the new candidates. If they felt that there wasn't a clear improvement, then they should be able to simply put the alternative candidates to shareholders for a vote (I'm not sure whether this can actually be done at present under existing rules for most companies - certainly it doesn't seem to happen!).

The only caveat I might add on the idea of a "slate" is that very often there are particular special skills or knowledge held by non-execs that may not be immediately obvious to those outside the boardroom. It would therefore be a good idea (if such a "shareholder-driven slate" is to take off) if candidates on the slate presented a similar skillset to those of a retiring non-exec  [eg....if the retiring non-exec is a lawyer, that may continue to be a required skill etc etc].

Bit of an over-long reply, but HTH.

ee

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About marben100

Marben100

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I am a full-time private investor... with a little trading on the side (generally small-scale arbitrage in specialist niches). Previously, I spent 24 years in the IT industry, 13 of those running my own IT services firm. I invested as a "hobby" for 20 years before turning it into a full-time occupation in 2004. I really enjoy the "research" side of investing, finding out about varied businesses and industries and learning what makes them tick. Since going "full-time" I have learnt an awful lot from some very erudite investors & professionals who are kind enough to share their expertise in electronc forums such as this. I can now count a number of them as my friends, having had the opportunity to meet them in the real world, as well as this virtual one! I try to pay back the debt I owe by sharing what I've learnt and I always value constructive criticism to correct my errors and misapprehensions! I am a Director of ShareSoc, the UK organisation for individual shareholders. See below for details.     more »


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